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Is it worth investing in net-nets?

I tend to post about net-net's fairly often on this site, they're an area of the market I think most people tend to avoid yet offer a lot of promise. I often receive objections to companies I write about, and most are perfectly valid and apply to most non net-net investments. I believe net-net's are a bit different than most investments and I want to take this post to address a few objections that I've seen with regards to net-net's.

What is a net-net

For all the writing I've done about net-net's I don't believe I've ever formally defined them. A net-net is a stock that is trading below the value of it's current assets (cash, receivables, inventory) minus all liabilities (short term liabilities, long term liabilities, all debt). A value this low is absurd, in theory a net-net could be liquidated and would give a positive return to shareholders if purchased at the current price. Given that property, plant and equipment aren't included in the calculation those values could provide even more possible upside if a company actually decided to liquidate.

The reality is very few net-net's actually liquidate themselves because management would be out of a job. So while a company might be trading below a conservative liquidation value it's unreasonable to actually expect a net-net to liquidate. A better way to look at liquidation value is as an absolute downside. Very few business sales that occur at arms length involve one company purchasing another for less than working capital, or for less than NCAV. If it's unreasonable for a business to sell to a private buyer for less than net current asset value (NCAV) why do such things happen in the market?

The margin of safety concept is that as an investor makes assumptions about an investment, value of assets, future earnings, quality of management and as they do they need to build in padding to their estimates to account for errors. A net-net gives a built in margin of safety, a business with a lot of warts is presented for sale at far less than a reasonable outside buyer would pay. To use the extreme example if the company was wound down even in that situation the net-net buyer would expect a positive gain.

As I work through different objections I've heard keep in mind the idea that a net-net is a company selling for less than current assets minus all liabilities or a reasonable liquidation value.

Objections

1) The business has no competitive advantage.

When I hear this objection I often think of the phrase "To the man with the hammer everything looks like a nail." There are many different approaches to investing, and the franchise style is just one of them. Not every company has a competitive advantage, I would actually argue a true competitive advantage is very rare. Investors are able to convince themselves they see one at every turn of the road, but I think that's just a bit of confirmation bias. I've seen some writers even mention that a net-net has a competitive advantage, I have news, if a company has a true competitive advantage it's not selling for less than NCAV.

Most companies are in competitive industries and earn an normal profit, a franchise company might earn an economic profit (above average). A net-net in all cases is not a company with a competitive advantage, if they had one why are they selling below NCAV?

A company doesn't need to have a competitive advantage to be successful. There are millions of businesses in the world that continue to pay employees and make their founders rich that have no advantage whatsoever. The companies have a small piece of market share in a crowded space, but it's enough to earn a profit, which is what matters.

A competitive advantage allows a company to earn an above average return, when evaluating a company selling below NCAV we don't need an above average return to be successful, any profit will be fine. In some cases no profit at all is needed because the assets alone are valuable.

2) This is a bad business in a bad industry

This is either the most valid or second most valid claim along with the following one. The problem is when people pose this objection they make it sound as if all bad companies and all bad industries expire eventually. While this would be great, it's simply not true. Many terrible industries continue to persist with companies happily making below average returns. One industry that comes to mind is the traditional phone. Landline phone calls are in steep decline yet there are companies that continue to exclusively serve this market, and will continue to serve it for years to come. Even though the demographics are bad wirelines will be around for a long time.

It seems shortsighted to ignore a company in a bad industry or a bad business because of general industry trends. I would agree with this notion if you're looking for a long term investment where you might want to buy an industry leader, but a net-net isn't that. A net-net is a company that even in a bad industry is selling for an irrationally low price.

One other parting thought here, sometimes a bad industry is a passing phase. In the 1970s railroads in the US were a very bad industry, they destroyed a lot of shareholder capital. The industry eventually consolidated and now railroads are considered a good industry with a competitive advantage. In the 1970s you could barely give away railroad stock, now Warren Buffett is buying railroads.

3) The company's management is bad

This is probably the most valid reason on the list, if a company's management steered the company into the current bad situation and the future course looks to be the same as the past it might be worth passing on the investment.

I don't think management's inclination to destroy shareholder value is isolated to net-net's, many large and well known companies bought back stock in 2007 at highs only to refuse to buy stock when their price cratered in 2009. Some of those companies even took out expensive debt in 2009 so they could have liquidity.

I prefer net-net's where the cause of the undervaluation is external and not due to management action. I specifically look for management that isn't going to spend excess cash on dubious acquisitions.

4) A company that cheap must be a fraud

I think this line of thinking has come out of the recent burst of China reverse merger stocks that are now showing up on net-net screens.

I don't think fraud is any more common with net-net's than with any other business. In all situations an investor needs to look for signs of fraud, check the quality of earnings, check accruals, look to see if there are signs balance sheet items might be fudged.

5) Since a stock's value is the present value of future cash flows the company is worthless because it's not a significant cash generator.

My response to this objection is similar to the first one, there is more than one way to go about valuing a stock. One way is to use a discount cash flow analysis which takes future guesstimated cash flows and assigns a present value to them. The sum of the guesstimated cash flows is what the stock should be worth. I know I'll probably get crap in the comments for using the word guesstimated, but unless the future cash flows are guaranteed by a bulletproof contract it really is a guess, maybe educated, but still a guess.

Another way is to attempt to buy a business for less than the hard tangible assets such as cash, inventory, factory, which is what buying a net-net is. When looking at a net-net we're evaluating the company on the basis of its assets, is the discount to asset value merited? Should this company be selling for less than a liquidation value? At times no discussion of the actual business is warranted, other times estimating the business value is of vital importance.

Summary

I think the key to looking at net-net stocks is to keep them in perspective. Yes these might not be great companies, but for the most part they are probably selling for incorrect prices. Sometimes you can find a great company that's hidden behind a wall of cash or a company that's stumbled on temporary hard times. In almost all cases these companies don't deserve their undervaluation.

17 comments:

I have invested in some net-nets but I prefer ones that are increasing book value.

My thoughts are how long will it take the market to recognize this particular net-net is cheap? If I own a net-net that is trading at a discount to NCAV of 10% and discount to book of 20% and it goes to book value (without any growth in book value) in 5 years, big deal. If that net-net is increasing its book value at 4% per year, the return is decent.

Of course if the market realizes the value in 1 year I am happy, or there can also be some homeruns where the market values the stock significantly above book (or receives a buy out).

Do you look at a certain hurdle rate? Or do you figure a portfolio of net-nets work out over time?

Thanks for the comment. You have a good point about the discount to NCAV and book being important.

I am usually looking for a 50% return if possible. So something at 2/3 NCAV or 2/3 book value will give that.

Sometimes if the business is decent and book value is growing I will need less of a discount if I plan to hold for a while. In this case I'm looking for 10-12% return. So if book is growing at 7% I will try to pay around 60% of book value or less.

I completely agree with the rational arguments you make above. Backtesting indicates that you are almost certainly correct, and for that reason I believe you will earn excess returns in net-nets.

But... aren't those same objections precisely the reason why most investors should avoid net-nets? Most investors are incapable of rationallity when sitting on ugly stocks like these. The painful psychological aspect of net-net investing leads most to sell net-nets at a loss.

On the other hand, most investors will have no problems at all riding a Fisher-style stock to riches. They can be a riot to own.

Have you read the recent post by Aswath Damodaran on investor's competitive "moats"?

I just reread that last line and I wanted to clarify that it wasn't intended to come across as offensive at all. You are obviously hard working, and skilled at identifying undervalued securities, in addition to having an iron stomach.

Thanks for the comments, no offense taken, I understood what you meant. I agree, temperament is probably the most important thing with holding a net-net. While the outlook appears terrible looking at the asset value and being able to think clearly that this company doesn't merit this valuation, then holding through the bad news. And there will be bad news, these companies aren't this cheap for no reason.

I saw the Moat article, it was good. I've owned and held and hold some moat stocks and can attest that the Fisher style does work. If someone can find a true Fisher franchise stock, but and hold they will do very well.

The flip side is most people see moats everywhere they turn and buying a mediocre business at a fair price will give an average return at best. For most people who hold a portfolio like this an index fund would be a much better investment.

I'd enjoy holding the Fisher stocks, but I also love getting in the dirt finding net-nets as well. The net-nets keep me busy and are far more exciting, but I'm not an exclusive investor one way or the other.

I'm a relatively new investor(opened my eyes to the world Feb 2011), since then I've looked at net-nets and I must say that I think 1 thing is overdone when talking about them. They aren't easy. There are great profits here but I think the objections you raised aren't the biggest objections to make. Here are my problems with net-nets.1. They're hard to find.An investor wanting to find a net-net has to work quite hard. Screening for them can find a few, but most of the screenable ones are terrible(my next point) and even the screeners that find net-nets aren't easy to find. In terms of free screeners I only know of Robotdough(on and off free...i think they're free now?) and OldschoolValue. I think stockscreen123 has some but I've found the screener there very tough to use.2. They're hard to analyzeSo you're going to devote the long hours to finding net-nets. Some people have it, they love it(count me as one of them). But some people find that extremely difficult. Next though, once you've found them, there is the obvious problem that the market believes that every dollar in the bank for the company is worth 0.667 in market value, and the business is worth nothing. Usually this means something is terribly wrong with the business. Many net-nets I've seen are either losing money or about to start losing money. Once you're good at stock analysis and can work your way in and out of SEC Filings,etc and have the time to do so, it's probably worth your while, but with net-nets I think you'll agree that every foot note counts, as there is no analyst to pick up your mistakes for you.

on the other hand, I personally love net-net investing, I love the thrill of finding net-nets and analyzing them. To your competitive advantage point, I think Geoff Gannon pointed out that PARF is a hidden champion b/c it has 80% market share in its little niche. I'd say that maintenance of market share is a type of competitive advantage, so I guess it's possible...but needless to say I get your point about competitive advantages, I think the lower quality of the businesses isn't a reason to avoid net-nets, but it definitely brings risk.

Buying dividend paying net-nets works best in my opinion. THis means they have income, growing balance sheet and you get paid to wait so you can still beat inflation while waiting.

Thanks for the comment. They can be tough to find, but have you ever looked at grahaminvestor.com? That site has all of the US net-nets and it's updated daily, probably the best site out there for them.

I would disagree that they're hard to analyze. I look for two things, do I have a solid margin of safety, and secondly is there anything that would impair my margin of safety. So if a tangible asset discount exists I want to make sure the operations aren't jeopardizing that. A company that's losing a lot of money does for sure, but one that's been consistently cash flow positive isn't. As long as I have a margin of safety and the operations aren't hurting my margin I can look at making an investment.

The biggest thing which a lot of people have commented on is the investor composition, I didn't mention this but it's key. The ability to hold a portfolio of small ugly companies through thick and thin.

I have invested in some nets-nets. I see few issues 1. Time is the essence, no matter how cheap you buy them. More time it takes lesser the return. How to figure out how long the market will take it to recognize , Something must happen for it to be recognized like a catalyst, change in management, etc ? 2. value of the net-nets is mostly in cash and management can do really bad stuff with cash like acquisition, keep losing money in current operations or will just sit on it forever. Again how to figure that out, mostly we depend on historical perspective and decision making of the management. 3. Most of the net-nets are owned by some individuals who run it like a private company and may do nothing to unlock value and what can a shareholder do in that respect

Yes, time period is a key factor. For me I try to follow two rules, either a 50% discount so trading at 2/3 NCAV or 2/3 BV or an investor return greater than 10% a year (ROE/BV).

If an investor buys at 2/3 NCAV and it takes 5 years for NCAV to be realized that's a gain of 10% a year which is respectable. Throw in some dividends and suddenly it's an incredible investment.

With regards to cash and management yes you need to be aware of those. I like companies with a significant insider ownership though they are less likely to shoot the company in the foot, because it's their foot. Of course these issues aren't isolated to net-nets, non net-nets face the same issues, bad management and empire building. Caveat emptor

Great read. In theory, what is to stop a net-net always trading as one? Doesn't there need to be some catalyst to drive value upwards..or do you believe that the market will eventually revalue undervalued companies based on mean reversion?

This is a common complaint, no catalyst exists how will value ever be realized? Ben Graham talked about this in a Senate hearing that the mechanism for a stock to move towards it's fair value is mysterious but it always happens over a period of 2-5 years.

I have issued the challenge to a few people in the past to show me a list of companies that traded below NCAV and have never risen above it since. I will point out that sometimes a company's IV declines to the NCAV price so what used to be a net-net is actually a fair value.

While I do agree with almost the whole article, I do think that fraud is more common with net-net's than with any other business for the simple reason that suspicion of fraud is one of the reasons that a company can be trading as a net-net.

The China RTO stocks illustrate exactly that point. If you blindly buy a basket of net-nets you will buy an above average amount of fraudulent companies.

Yes, these lists have become a bit more junked recently due to the China issues.

So I don't consider the China fraud's real companies, and I exclude anything from China from any consideration. I would highly advise others to do the same.

If someone does just buy all the US net-net's and doesn't pick out the China ones I agree results will be disappointing. I don't think the same could be said if they bought all of the net-net's that aren't Chinese.